The Corporate & Commercial Law Society Blog, HNLU

Tag: Banking Law

  • Aligning RBI Directives with DPDP Act in the Banking Sector

    Aligning RBI Directives with DPDP Act in the Banking Sector

    BY VISHWAROOP CHATTERJEE AND NACHIKETA NARAIN, SECOND-YEAR STUDENTS AT RGNUL, PATIALA.

    Introduction 

    The intersection of banking and data protection is perhaps the next big leap for both the sectors. The banking sector is one of the most prone and vulnerable spaces for massive data breaches that can have severe financial and legal consequences. The lack of an effective cybersecurity infrastructure will lead to an onslaught of cyber-crimes such as fraudulent financial activities, phishing, data selling, ransomware, etc. The Government has introduced the  Digital Personal Data Protection Act (‘DPDP Act’) and the proposed Digital India Act which sheds positive light on the government’s intention for data protection. However, the mere introduction of legal provisions is not the solution, corporations have been notorious for acting as data brokers which results in data leaks. As a result, the financial data has always been prone to data breaches. 

    In this article, the authors shall deal with the analysis of the current laws that govern data protection with an understanding of the DPDP Act and its emphasis on the role of RBI as the watchdog of data privacy in the banking sector. 

    Failure To Comply with Data Protection Protocols: The Kotak Mahindra Bank Incident

    Digital banking is the new norm and yet, banks have been failing to be well equipped with a robust digital infrastructure for the protection of their consumer’s data. The recent actions against Kotak Mahindra Bank by the apex financial institution (‘RBI’) under Section 35A of the Banking Regulation Act, 1949 is an example of failure of banks to equip themselves with robust digital infrastructure for the protection of consumer data. RBI has barred the mentioned bank from onboarding customers through its online service platforms and issuing new credit cards. According to the RBI, Kotak Mahindra Bank failed to comply with various data protection protocols, and deficiencies were identified in IT inventory management, risk vendor management, data security and data leak prevention strategy, etc. RBI had notified the mentioned bank in 2022 and 2023 about the security lapses and provided them with a corrective action plan which Kotak Mahindra failed to comply with. A well-established Indian Bank failing to meet RBI’s data protection protocols is a worrisome event as other banks might follow if these lapses are left unchecked. 

    Data Privacy in Banking Sector

    In the case of  HDFC Bank Limited v. Jesna Jose,   it was held that with the advent of the digital age, the bank must be held liable for any unauthorised transaction or fraudulent activity from an act arising out of the bank’s negligence. This was done to keep a watch on the banks’ data privacy systems and to ensure that they minimise any unauthorised or fraudulent activity. The judgement relied upon the precedent set by the Chairman, Punjab National Bank v. Leader Valves Ltd which held that if the bank manages the account, it is incumbent upon the bank to ensure the safety and security of the account. The section 43(a) of the Information Technology Act, 2000 deals with the liability of a corporate body to compensate in instances of failure to protect sensitive data. Most importantly, the master direction issued by RBI on IT outsourcing services serves as a cornerstone to keep third-party data processors in the financial ecosystem in check.  

    One question that may arise here is, does RBI have the legal jurisdiction to enforce banks with data privacy compliances? In the case of Internet & Mobile Assn. of India v. RBI, (2020) one of the issues was the jurisdiction of RBI in matters not directly linked with traditional monetary policies. The judgement held that when RBI is not any other statutory body but a creature on its own that can exercise its power in its capacity for policymaking, operational risks or  regulation for enforcement and such directions would become supplementary to the Reserve Bank Of India Act, 1934 itself. Hence, it becomes a duty for the banks to comply with the data privacy directives of RBI.

    Analysis and Suggestions to the DPDP Act

    In the digital economy, consumers utilise the financial services offered to them by giving their personal data. This trade of confidential data for financial services is a highly sensitive aspect that must be backed by sturdy mechanisms protecting the confidentiality of sensitive data from misuse. 

    The most prominent issue that arises with the DPDP Act is that it has failed to differentiate between personal data and sensitive personal data. Under Section 2(h) of the Act, it defines data as the representation of information, facts, concepts, opinions or instructions in a manner suitable for communication, interpretation or processing by human beings or by automated means. This classification may perhaps be too vague in the realm of the banking sector since it deals with highly sensitive consumer data that needs greater protection than other personal data since it contains sensitive financial information besides personal information. 

    The first suggestion is to classify the various types of data that need regulation. The vague definition is restrictive for the efficient regulation of different data sets. Therefore, there should be categorisation of data sets. The EU GDPR, UK GDPR, and US state laws like the California Consumer Privacy Act categorise certain types of data as ‘sensitive’ and deserving of extra protection. The DPDP Act can take a similar approach. This will provide clarification to data fiduciaries in the banking sector to regulate sensitive financial data with a well-defined approach.

    Moreover, the DPDP Act has misaligned accountability with respect to data fiduciaries and data processors. It defines data fiduciaries essentially as corporations who possess customer data and determine how the data will be processed. Whereas, a data processor is an entity that processes the data on behalf of the fiduciary.  The DPDP Act focuses on the guidelines for the data fiduciary and leaves the data processors with minimal regulation. The only significant element for data processors is subsection (9) of section 9 which states that a data fiduciary must have a contract with the data processor. 

    The DPDP Act falls short of providing the necessary clarity for processors on how to handle such data. Firstly, it fails to specify the security controls that processors are expected to implement. Secondly, the Act is deficient in outlining clear protocols for processors to follow in the event of security lapses. Lastly, the Act neglects to establish clear guidelines for handling requests for data from government authorities, resulting in ambiguity and potential liability issues. 

    This essentially makes it clear that there are hardly any guidelines or standards that ensure that these data processors undertake their responsibilities in a safe and secure manner so as to protect the sensitive data they handle; these data processors can ultimately emerge as the ‘unruly horse’ in the digital realm. This necessitates the framing of certain standards which the data processors comply with. Chapter 5 of the Master Direction by the RBI can be referred that clearly outlines the rules of the agreement pertaining to the data processors. 

    Hence, the second suggestion is to properly define the roles of the data processors in the DPDP Act like the RBI has done for its regulated entities by clearly laying out a roadmap that gives directions to data processors on data breaches, storage of data, risk management and etc. The relationship between data fiduciaries and data processors cannot be sufficed by a mere contractual agreement. 

    Some of the directions for data processors can be referred from the RBI Master Directions. As per this, the service providers (similar to data processors) are required to define the services they will deliver and the standards they will adhere to in order to meet in terms of quality and quantity. Moreover, the service provider is responsible for maintaining confidentiality and security of the data with ‘Regulated Entity’ (similar to data fiduciaries) pertaining to the customers or its own data. The agreement should define as to which data can the service provider share with other entities.

    Conclusion 

    The world of technology is adapting and the Banking and Finance world cannot be left behind. The RBI must act as the custodian of Data Privacy in the realm of Banking and Finance. The current DPDP Act needs revision and needs to be harmonised with the RBI directives to provide better clarity for the data protection of the finance world. 

    Moreover, it would be essential for the DPDP Act to categorise the various Data types as they may be susceptible to varying levels of risk. The Act must also adapt or incorporate RBI’s master directions on IT outsourcing to clearly establish the roles of Data Fiduciary and Data Processors. The legal ambiguity with the data processors is a regulatory gap that must be dealt with to create an efficient digital banking sector. India’s digital economy generating about $200 billion of economic value besides also being the second-fastest digitizing economy. Therefore, it is necessary for India to advance these data protocols. A secure digital infrastructure provides consumer trust and safety which paves the way for a resilient and sustainable banking sector. 

  • PCA Framework as an Effort to Contain the Contagion Effect

    PCA Framework as an Effort to Contain the Contagion Effect

    by Abhishkha Moyal, 5th year law student at RGNUL, Patiala.

    Introduction

    A non-banking financial company (“NBFC”) means, (i) a financial institution which is a company; (ii) a non-banking institution which is a company, with principal business of receiving deposits under any scheme or arrangement or in any other manner, or of lending in any manner;; (iii) such other non-banking institution or class of such institutions, as the Reserve Bank of India may, with the previous approval of the central government and by notification in the official gazette, specify.

    Every NBFC in India deals with substantial number of customers as well as with other NBFCs. NBFCs also partners with digital lenders who have restrictions on lending funds on their own accounts by reason of regulatory issues. Hence, the NBFCs form an important part of the financial system of India and enormously impact the economy as a whole. Any default made or any financial discrepancy caused by a single NBFC can create a substantial risk for the financial system of our country, thereby causing a ‘contagion effect’, that is, escalation of economic crisis in one market or region leading to economic downturn in other national or international markets or regions due to interconnectivity between them. . However, the regulatory framework for NBFCs is lenient in comparison to that for the banks due to which the financial system of India in recent times has suffered various jolts like the collapse of Infrastructure Leasing & Financial Services group in 2018, and bankruptcy of Dewan Housing Finance Corporation in 2019 and Reliance Capital in 2021.

    The Reserve Bank of India (“RBI”) introduced the Prompt Corrective Action (“PCA”) framework for NBFCs on December 14, 2021 in order to intervene at the appropriate time to initiate and implement remedial measures in a timely manner, so as to restore financial health of NBFCs which are at risk. The framework will be effective from October 1, 2022, on the basis of financial position of NBFCs on or after March 31, 2022.

    Working of the PCA Framework

    The applicability of PCA framework shall extend to all deposit taking NBFCs (except government companies), and all non-deposit taking NBFCs in middle, upper and top layers
    (except- NBFCs not accepting or intending to accept public funds; government companies; primary dealers; and housing finance companies). The key areas for monitoring in PCA framework will be capital and asset quality, and indicators to be tracked would be Capital to Risk Weighted Assets Ratio (“CRAR”), tier I capital ratio and net non-performing assets (“NNPA”) ratio. The NBFCs will face restrictions when such indicators fall below the stipulated levels.

    The PCA framework provides for three risk thresholds for NBFCs, violation of any of which by any NBFC may lead to invocation of PCA framework by the RBI against such NBFC. The norms which RBI may impose on such NBFC will get stricter as and when such NBFC moves from the first to the third threshold. First risk threshold will be invoked for the NBFCs when the CRAR of such NBFC falls 300 basis points (“bps”) below the regulatory minimum of 15% or when tier I capital ratio falls 200 bps below the regulatory minimum of 10% or in cases where NNPA ratio exceeds 6%. In such cases, it will be mandatory for the NBFC to restrict dividend distribution/remittance of profits. Further, it will be mandatory for promoters/shareholders of such NBFCs to infuse equity and reduce leverage. 

    Similarly, the second risk threshold will be invoked when CRAR falls up to 600 bps below regulatory minimum of 12% or when tier I capital ratio falls up to 400 bps below the regulatory minimum of 8% or in cases where NNPA ratio exceeds 9%. In such cases, it will be mandatory for the NBFCs to restrict their branch expansion, in addition to the restrictions imposed after breach of first risk thresholds. 

    Further, the third risk threshold will be invoked when CRAR falls more than 600 bps below regulatory minimum of 9% or when tier I capital ratio falls more than 400 bps below the regulatory minimum of 6% or in cases where NNPA ratio exceeds 12%. In such cases, it will be mandatory for the NBFCs to impose restrictions on their variable operating costs and capital expenditure, except capital expenditure on technological upgradation within limits approved by their board of directors. In addition to the above restrictions, the PCA framework gives discretionary powers to the RBI to take certain other actions against the defaulting NBFCs relating to governance, capital, credit risk, profitability etc. 

    NBFCs can exit from the PCA framework and the restrictions imposed against them and the PCA framework can be withdrawn under two conditions. Firstly, there should have been no violations of risk thresholds in any of the parameters for four continuous quarterly financial statements, one of which should be annual audited financial statement (subject to assessment by RBI); and secondly, on the basis of supervisory comfort of the RBI, including an assessment on sustainability of profitability of NBFCs.

    Impact

    The PCA framework was introduced for the banking companies in 2002. Eleven public sector unit banks and some private banks were put under the framework; restrictions were imposed on such banks to improve their financial health as a result of which their financial health improved over the years. At present only the Central Bank of India is governed by the PCA framework, however, it has also enhanced its financial position and no longer requires working under the framework. 

    As mentioned earlier, the PCA framework will come into effect from October 1, 2022, based on the financial position of NBFCs on or after March 31, 2022. This will give NBFCs sufficient time to strengthen their financial position, which may have been affected by the Covid-19 pandemic, and avoid any other issues. 

    Imposition of the PCA framework will enable the RBI to (i) regulate NBFCs struggling with financial issues; and (ii) help such NBFCs to resolve such issues in a timely and effective manner. Moreover, empowering the RBI to intervene with the working of struggling NBFCs in order to strengthen their financial position will prevent such NBFCs from advancing risky loans and will encourage them to be more cautious in undertaking lending and other activities. However, this may have a negative impact on the growth of the NBFCs, as imposition of the PCA framework on the NBFCs will tighten their credit norms and their operational focus may shift towards collection activities.

    Conclusion 

    The PCA framework for banks has already been in place since 2002 and has helped the RBI and many other banks to improve their financial health. As NBFCs have become closely integrated with the banking and financial system of India, hence, regulating them is the need of the hour in order to maintain a stable financial system. 

    Moreover, as the Covid-19 pandemic has adversely affected many businesses around the world, it would be rational for NBFCs to lend their funds discreetly in order to avoid financial difficulties at later stages. When remedial measures are implemented in a timely manner for NBFCs at financial risk, it will help in containing the contagion effect on the economy.

  • Cryptocurrency And Dispute Resolution

    Cryptocurrency And Dispute Resolution

    BY PRIYA AGARWAL, FIFTH-YEAR STUDENT AT RMLNLU, LUCKNOW AND RIYA AGARWAL, FOURTH-YEAR STUDENT AT VIPS, IP UNIVERSITY, DELHI

    Disruptive Technology is any innovation that changes the way how the industry and markets operate. Its attributes are comparatively superior and therefore can change consumer behavior and sweep away old practices. Television, Radio, and GPS, etc. were all disruptive technologies in their own time. Currently,  the most talked about disruptive technology is ‘Blockchain’ which is often confused with Artificial Intelligence (‘AI’) but is quite different as AI delivers completely new services while Blockchain has the potential to revamp currently existing processes.

    Blockchain, in simple terms, is a register or distributed ledger. It is an open-ended decentraliSed software platform enabling smart contracts and decentralised applications. “Each transaction is added to a chain of all previous transactions, validated by a network of computers”[i], before being added to the network, and thus creates a Blockchain. Two of its main characteristics are a decentraliSed way of tracking ownership of property, and the ability to directly transfer property. One of the most important products of blockchain technology is Cryptocurrency.

    Cryptocurrency is a virtual or digital currency secured via cryptography and functions outside the control of any bank. It is a record of transactions (blockchains) kept on a decentralized database, which can be accessed by all members and is updated whenever another transaction is verified, which implies that choices influencing the database are made by an agreement of the users of that blockchain.[ii] It provides a certain level of pseudonymity as the members use a digital, blockchain wallet to send money and conduct their operations and every wallet is connected to a key and not to names and addresses.

    Cryptocurrency in India

    Cryptocurrency exchanges started to operate in India in a regulatory vacuum. There was neither a legislation defining it nor one prohibiting it. They grew and the RBI started taking measures to control its use without defining it. In June 2013, RBI through its Financial Stability Report defined Virtual Currency (‘VC’) as “A virtual currency can be defined as a type of unregulated, digital money, which is issued and usually controlled by its developers, and used and accepted among the members of a specific virtual community.”[iii]In 2013, RBI issued a caution to users dealing in cryptocurrency of the risks involved. In July 2017, the Inter-Disciplinary Committee advised against engaging in VCs and also insisted the government to take legislative measures. And finally, in April, 2018, RBI issued a circular prohibiting dealing in VCs to regulated entities. These regulated entities were instructed to quit the relationship within three months. This Circular was challenged in the case of Internet and Mobile Association of India v. Reserve Bank of India[iv].

    The Petitioners made the following contentions:

    1. the legal character of VCs i.e. it is not money but good,

    2. it is a property as it is stable, definable, permanent and can be exclusively controlled;

    3. the circular violates the rights of the petitioners under Article 19(1)(g) of the Constitution to carry on their occupation, trade or business;

    4. the RBI has acted beyond the scope of its powers and arbitrarily;

    5. the RBI acted in a predetermined manner and jumped the gun in virtually outlawing VCs.

    The court found that while the RBI has the power to regulate VCs, the prohibition imposed is disproportionate; as it did not consider less intrusive measures and, therefore, ultravires the Constitution. In the absence of any legislative prohibition, dealing in these currencies must be treated as legitimate.

    The verdict had a positive impact on the fintech landscape of the country but, various members of the legal community believe that this festive mood is going to be a short-lived affair if “Banning of Cryptocurrency and Regulation of Official Digital Currency Bill, 2019” is passed. However, in the absence of any regulation, the transactions and dealing with regards to cryptocurrency may witness many disputes.

    Potential Disputes

    One of the most innovative uses of cryptocurrency is using it for investment via Initial Coin Offering (‘ICO’). In an ICO, a company may issue coins in exchange for money or any other cryptocurrency. This coin may act as an equity share providing dividends and voting rights etc. These coins can also function as retailer loyalty programs providing specific products or services by the company. Similar to any venture involving investment put to risk, uncertainties regarding the allocation of risk or on the basis of which risk was assumed give rise to disputes.

    For instance, during an ICO the issuing company may provide certain information to the investors including the prospectus and the offering memorandum. A possible breach of the terms of such a memorandum can give rise to a claim and therefore it is important to include logical dispute resolution mechanisms in such documents. In the Bancor Foundation ICO, the network congested due to high demand, moreover the offering was kept open longer than planned which enraged the early investors who claimed that the initial cap was exceeded and the value of the coins purchased before was depreciated.

    Many disputes can arise out of the failure of the blockchain system itself. In 2016, the Ethereum cryptocurrency platform was hacked and cryptocurrency worth $64 million was siphoned off. Investors who experience the ill effects of similar disappointments in the blockchain fundamental to their cryptocurrency investments may normally wish to acquire damages from the platform provider.

    There is also uncertainty whether these economic activities in this industry would be classified as an “investment”. To answer this, it may stated that such characterisation is possible under the broad ambit of “investment” provided in major investment treaties. Regulatory policies offered by the USA explains the complexity of the subject. The US has developed the required regulations for the treatment of these activities as an investment, however, the US Courts, in several cases, have treated cryptocurrencies as a form of money, while in India, the legality of cryptocurrency is not defined. while in countries like India, the courts and legislatures have remained largely silent on the legality of cryptocurrency.

    An investor makes an investment based on several considerations such as risks and profits. In the case of cryptocurrencies, there are no geographical or other considerations to be made and the foreign country’s legislation seems to be the only decisive factor. Under the existing investment regime, laws of a state may be attractive or otherwise ‘inherently prospective’, defined in the case of Total S.A. v. Argentine Republic as a division between the specific investment laws of the state, which entail a certain legal expectation and the general regulatory framework, which is more difficult to be understood as to create such expectations. Anyhow, according to the decisions held in Enron v. Argentina[v] and CMS v. Argentina[vi], an investor can hold the state liable for breach of legitimate expectations in case of any amendment to laws that were an incentive for investment.

    One of the major concerns for the cryptocurrency is the anonymity of transactions, which may justify the change in policy by the state. Central Banks and Financial Regulators all over the world discourage people to deal in cryptocurrency as it may be used in illegal activities like money laundry, tax evasion, terrorism, etc. Moreover, the governments also fear that it might undermine the value of the national currency as third party actors may be able to speculate the prices of goods and other crucial issues of sovereign nature.

    Arbitration as a means of Resolving Cryptocurrency Disputes

    Disputes arising from borderless currencies may be best served by a borderless form of dispute resolution and thus arbitration is the preferred means for resolution of blockchain-based disputes, given the international profile of ICO investors.

    Arbitration is a non-national and neutral dispute resolution forum that enables the parties to nominate a tribunal or technical specialists to efficiently and effectively resolve the different types of disputes that may arise. The ease of cross border enforcement also makes it highly compatible with the transnational nature of technology and investors of the blockchain industry.

    The award provided in arbitration is enforceable in 157 countries under the New York Convention. Moreover, it ensures flexibility to the parties as the parties can choose experts of the field and arbitral rules can be customised to suit the peculiarities of cryptocurrency disputes, while protecting the confidentiality of sensitive propriety information.

    Indeed, the inherent flexibility of the arbitral proceeding enables efficient conflict management approaches to be developed. The flexibility of arbitration can also enable the parties to agree to an arbitration procedure which helps to head off the challenges that arise from the pseudonymity of users on the blockchain and the immutability of published ‘blocks’.

    While uncertainty remains regarding the classification of crypto-based transactions as ‘investments’ under the existing investment arbitration regime, the regulation and ban by certain states mean that investment arbitration can be used as a viable option to resolve regulatory disputes.

    Therefore, the arbitrators should promote the benefits of arbitration and its usage to the tech sector. Moreover, there is a scope to develop model arbitration clauses regarding cryptocurrency disputes and make modifications to institutional rules accommodate such disputes better.

    Conclusion

    Arbitration is well-placed to cater to a new breed of disputes, as long as its practitioners are prepared to evolve rapidly to meet their clients’ developing needs. New Dispute resolution procedures must be looked into like Online Dispute Resolution (‘ODR’), Blockchain arbitration etc. that are efficient and better at preserving the gains created through the use of blockchain even when a dispute arises. Blockchain technology is rapidly developing and is being adopted by several businesses and industries, therefore the interplay between blockchain and arbitration will grow and legal professionals and arbitrators must be well equipped in handling the forthcoming plethora of disputes.

    [i] Reggie O’Shields, Smart Contracts: Legal Agreements for the Blockchain, 21 N.C. Banking Inst. 177 (2017).

    [ii] James Rogers and Ayaz Ibrahimov, Cryptocurrencies and arbitration: A match made in heaven?, Norton Rose Fulbright International Arbitration Report, 25, 25 (May 2018), https://www.nortonrosefulbright.com/-/media/files/nrf/nrfweb/imported/20180416—pdf-file—interntional-arbitration-report—issue-10.pdf?la=en&revision=958b9eac-61b9-416d-8111-350583176022.

    [iii] Financial Sector Regulation and Infrastructure, Reserve Bank of India, (Jun 23, 2013),  https://www.rbi.org.in/scripts/PublicationReportDetails.aspx?UrlPage=&ID=709.

    [iv] 2020 SCC Online SC 275.

    [v] ICSID Case no. ARB/01/3, Award, 2007, paras. 264 – 268.

    [vi] ICSID Case no. ARB/01/8, Award, 2005, para. 274.

  • The Future of Financial Institution Resolution Mechanisms: FRDI to Make a Comeback?

    The Future of Financial Institution Resolution Mechanisms: FRDI to Make a Comeback?

    By Anirudh Rao Saxena and Anupriya Nair, Fourth-year students at NALSAR, Hyderabad

    An air of uncertainty and impermanence surrounds the future of the Indian financial system as a result of COVID-19. On 11th July 2020, speaking at the State Bank of India (SBI) economic conclave, RBI Governor Shaktikanta Das voiced his concerns pertaining to a likely increase in cases of capital erosion and non-performing assets (“NPA”) in the banking sector, as a result of the pandemic. As a contingency response to these vulnerabilities, he proposed the setting up of a resolution corporation (“RC”) with requisite legislative support to aid in the insolvency management of financial firms.

    Chronology of Events

    The necessity to establish an RC for insolvency and liquidation proceedings of Financial Service Providers (“FSPs”) was originally observed in the controversial Financial Resolution and Deposit Insurance Bill, 2017 (“FRDI”). The late Finance Minister (“FM”), Arun Jaitley, in August 2017, launched the FRDI in the Lok Sabha. Subsequently, in August 2018, interim FM Piyush Goyal withdrew the FRDI owing to public anxieties surrounding a ‘bail-in’ clause which was put in place to combat issues of inadequate deposit insurance.

    In February 2020, FM Nirmala Sitharaman announced that although the revival of the FRDI is in the works, the Ministry of Finance cannot commit to a timeline for it to be tabled in Parliament. Currently, media reports suggest speculation around a forthcoming revised Financial Sector Development and Regulation (Resolution) Bill, 2019 (“FSDR”) in accordance with a briefing note prepared by economic affairs secretary, Atanu Chakraborty.

    A Primer on FRDI

    The prime reason for the introduction of FRDI was due to the increasing interaction between the public and the financial sector. It was owing to this very reason that the government felt a need to protect the interests of the depositors. Furthering this intention, the government introduced the contentious FRDI Bill, 2017 in the Lok Sabha.

    Presently, India lacks an all-inclusive and integrated legal framework for the resolution and liquidation of financial firms. The responsibilities and powers for resolution are dispersed amongst regulators, Courts and the Government under multiple laws. These powers are quite limited, therefore banks are typically restricted to two methods of resolution i.e. winding up of the bank or mergers. Further, the impact of failure in case of a traditional insolvency procedure is limited to the creditors of the insolvent firm, however the failures of financial providers have a much wider ramification on the economy of a country (Cypriot Financial crisis). Thus, just as the Insolvency and Bankruptcy Code, 2016 (“IBC”) has provided a comprehensive resolution mechanism for non-financial firms, the FRDI Bill aims to do the same  for financial institutions.

    What Triggered the Withdrawal of FRDI?

    The foremost trigger behind the withdrawal of the FRDI was the questionable ‘bail-in’ clause found in Section 52 of the Bill. This section allowed for, if the RC saw fit, the internal restructuring of liabilities (deposits). Moreover, further sub-sections of the clause provided for the cancellation and modification (into long-term bonds and equity) of deposits. It is notable that the extent of the powers of the RC in this regard would be applicable on deposits only beyond the insurance cover amount of INR 1 lakh. Inevitably, this clause led to apprehension among depositors owing to the possibility of being left with a mere 1 lakh in case of bank failure.

    In response to public concerns surrounding the ‘bail-in’ clause, not only the Ministry of Finance, but the late FM Arun Jaitley himself, presented the clause as a transparent means of granting additional protection to deposits. Au contraire, The Associated Chambers of Commerce & Industry of India (“ASSOCHAM”) argued against the clause, bringing focus to the dangers of diminishing trust in the banking system and of the consequent routing of public investment into unsuccessful avenues leading to the eventual erosion of the banking system. The competing objectives of the Bill, and that of the depositors, led to debate resulting in the withdrawal of the Bill.

    The Revival of FRDI in 2020: Understanding its functioning

    FRDI aims to provide establishment of a RC and a regime which would enable a timely resolution of failing financial firms. The RC will consist of representatives from all financial sector regulators (the Reserve Bank of India, the Securities and Exchange Board of India, the Insurance Regulatory and Development Authority of India and the Pension Fund Regulatory and Development Authority), the ministry of finance as well as independent members. It aims to achieve timely intervention by classifying firms into 5 categories – low, moderate, material, imminent, or critical. Determining the health of a financial entity, ensures that a timely decision can be taken before it’s classified as a weak entity and there is no other option left but to liquidate the firm.

    The liquidation waterfall mechanism sets up a priority in terms of dispersal of payments  on the occurrence of liquidation. According to the hierarchy, first priority is given to secured creditors, followed by unsecured creditors, and finally by operational creditors. Under the current regime regulated by Deposit Insurance and Credit Guarantee Corporation (“DICGC”), the deposits are insured up to INR 1 lakh  over which the deposit is treated on par with unsecured creditors. However, as per the provisions of the FRDI Bill, these uninsured deposits will be placed above unsecured creditors and Government dues. FM Nirmala Sitaraman, in her 2020 budget speech, announced that the limit for insured deposits would be increased to INR 5 lakhs. This move would ensure improved protection of the rights of the depositors since a larger sum of deposits are protected. For this transition to occur in a seamless way, the FRDI Bill would have to transfer the deposit insurance functions from the DICGC to the RC which would then result in an integrated approach to the depositor’s protection and resolution process.

    Decoding the Status Quo

    The status quo of FRDI may be ascertained from the assertions made by RBI Governor Shaktikanta Das as part of his recent speech at the aforementioned SBI economic conclave. On account of similarities between his proposal and the FRDI with respect to the suggestion to set up an RC, the re-emergence of a revised FRDI may be easily perceived.

    First, Das drew attention towards the increased relevance of resolution as opposed to liquidation of banks. He cited resolution (wherein the bank remains a going concern) as being more effective in providing depositors with a higher value of return.

    Second, the traditional merger approach often utilized to save failing banks by merging (The merger of Corporation Bank and Andhra Bank with Union Bank ) with larger banks, doesn’t provide the same return as the resolution process.

    Third, Das stressed upon the necessity to have the RC acting beyond simple implementation of corrective measures. The primary focus of the RC, as he stated, is not to correct, but to monitor, foresee and assess emerging risks as and when they surface.

    Interim Mechanism

    On 15th November 2019, the Ministry of Corporate Affairs (“MCA”) notified the Insolvency and Bankruptcy (Insolvency and Liquidation Proceedings of Financial Service Providers and Application to Adjudicating Authority) Rules, 2019 (“Rules”) with the objective to provide a framework for insolvency and liquidation proceedings of FSPs other than banks.

    The Rules shall be applicable to FSPs (to be notified by the Central Government) as per Section 227 of the IBC including discussions with appropriate regulators, for the purpose of conducting insolvency and liquidation proceedings within a specified time frame. It is imperative to comprehend the provisional nature of the framework provided under Section 227 as it has been set up as an interim mechanism until either a revised legislation is enacted, or the IBC is amended.

    The Way Forward

    It is important to analyze and address the position FSDR will take in its proposed reforms. The bail-in clause was problematic in the FRDI owing to the lack of coherent legal framework within which it operated. This ultimately resulted in disproportionately disadvantaging individuals while leaving the corporate and financial sectors unharmed. In order to preserve financial stability, it is essential that the new Bill is strategically designed to establish a balance between the rights of private stakeholders and public policy interests.

    The FSDR should consider including the “no creditor worse off test” in order to safeguard stakeholder interests. This move will convince investors that the bail-in provision is merely a way in which the bank buys time to restore its strength and long-term viability. This framework has been tried and tested during the 2011 Denmark financial crisis, and was advocated by the International Monetary Fund. It is of utmost importance that the bail-in framework is carefully structured to ensure effective implementation in the FSDR.

    Additionally, owing to the constant changes in the dynamics of the banking sector with various mega sector banks undergoing mergers, it would be ideal to wait until there is better clarity on the future of the banking sector before introducing a new Bill. In order to better incorporate the legislative framework of other acts with the functioning of a new Bill, multidisciplinary research should be conducted before its enactment.

  • NPA Crisis: Pressing Need For Bad Bank

    NPA Crisis: Pressing Need For Bad Bank

    BY ADITI SINGH, GRADUATE FROM SYMBIOSIS LAW SCHOOL, PUNE

    Indian banks especially the public sector banks are heavily burdened with bad loans and an ongoing pandemic is further making the crisis worse. For banks to effectively operate, it’s imperative that they continue lending loans and advances which are categorised as a standard asset or a non-performing asset (‘NPA‘). In an event when the borrower defaults in payment of interest or principal amount of loans and advances made by the bank for more than 90 days, the asset which was earlier categorized as a standard asset is then converted to an NPA.

    According to the Financial Stability Report the Gross NPA ratio of Scheduled Commercial Banks may rise from 8.5% in March 2020 to 12.5% by March 2021 under the baseline scenario however the same may be escalated to 14.7% under a very severely stressed scenario. Banks suffer enormous losses in provisioning for already existing NPAs, due to the Covid-19 pandemic, the world has been facing economic slowdown which has forced the Reserve Bank of India (‘RBI’) to allow a moratorium period and the government to suspend resolution procedure under Insolvency and Bankruptcy Code which will further burden the already burdened banks with NPAs.

    Asset Reconstruction Companies away from Efficient Resolution of NPAs

    There are Asset Reconstruction Companies (‘ARC’) registered with the RBI and regulated under the SARFAESI Act, 2002 that purchase NPAs from the banks at a discounted price and then focus on realising such financial assistance. In order to secure finances, ARCs under section 7 of SARFAESI Act, 2002 are authorised to issue security receipts to qualified buyers evidencing the purchase or acquisition by the holder thereof, of an undivided right, title or interest in the financial asset involved in securitisation. However, ARCs have not been able to provide relief to the stressed banking sector. ARCs have been poorly capitalised to purchase NPAs from the banks and to make 15% of upfront payment as required. Even if ARCs have capital to purchase NPAs the price offered by them after haircut is far too less for banks to agree upon which is why the banks delay and avoid to put NPAs for auction. Delay by the banks in selling NPAs to ARCs leaves restrictive space for ARCs to realise the stressed assets, ultimately defeating the entire purpose behind ARCs existence. Looking at the near future, Indian Banks’ Association has proposed to set up a ‘Bad Bank’ for the recovery of banking sector from the financial distress.

    How will Bad Bank resolve NPAs? How will it work differently from already existing ARCs? Who will fund the Bad Bank in India? These are some of the questions that come hand in hand with the discussion of establishing Bad Bank.

    The Bad Bank Approach

    A Bad Bank essentially is an ARC which aims at reducing NPAs from the books of banks thereby reducing the load of stressed assets upon the banks. The banks will first segregate their assets and then transfer their stressed assets to the Bad Bank. The Bad Bank will then focus on realizing those stressed assets.

    Experiences of United States of America, Ireland, Germany, Sweden, Malaysia suggests various significant features behind success of Bad Bank. Mellon Bank of USA was the first bank to use the Bad Bank approach to resolve stressed assets. Further, The United States established, the Resolution Trust Corporation in the year 1989 funded by government and a few private investors. Thereafter, in the year 1992 Sweden incorporated Securum, a state sponsored company to resolves stressed assets, which successfully resolved ailing assets and was closed in the year 1997. Some of the major factors behind its success were state intervention, well framed laws and policies, transparency and political unity.

    Another significant model is Danaharta, established by the Malaysian government in the year 1998, a government funded asset management company with finite life to resolve stressed assets and recapitalisation. Malaysian government focused on strengthening its laws to support the effective operation of Danaharta. Malaysian government also stressed upon involving experts around the world which contributed immensely towards its success. However, there is no correct model for Bad Bank but intervention of state in ownership of Bad Bank needs to be carefully determined before establishing Bad Bank in India.

    The structure of the Bad Bank will be the main area which will distinguish it from the already existing ARCs in India. Indian Banks Association has proposed three stages of Bad Bank which includes an Asset Reconstruction Company (‘ARC‘) which will house the NPAs, an Asset Management Company (‘AMC’), and an Alternate Investment Fund (‘AIF’). The ARC will be owned by the Government of India, the AMC will be a professional body with participation from public and private sector, and the AIF is where a secondary market can be created for security receipts. The association recommended that the capital of Rs. 10,000 for Bad Bank to start operating shall be funded by the government.

    The idea of Bad Bank has been avoided for a long time in India. However, looking at the enormous number of distressed assets it becomes significant to find a way to resolve them. The role of ARCs and IBC has been significant yet not sufficient to resolve enormous number of NPAs. Bad Bank which is essentially an ARC has the potential to get financial sector ready to release funds. Some of the significant factors that will help the Bad Bank to effectively operate and resolve the enormous amount of bad loans in India are as follows:

    Structure of the Bad Bank

    The structure is the significant feature that will distinguish it from ARCs. Amid Covid-19, it is unreasonable to expect state owned Bad Bank, even otherwise Bad Bank requires minimum state intervention. However, Experiences around the world are a testimony that the state cannot be entirely excluded from the ownership structure of Bad Bank.

    The suitable structure for Bad Bank would be a Public-Private Partnership (‘PPP‘) to maximise recovery. Size of NPAs in public sector banks is such that the Government cannot be entirely excluded from the ownership but can stand as a minority stake holder so that the bank has the commercial freedom and transparency to avoid red-tapism while resolving the stress of bad loans.

    Adequate guidelines and Framework: For Bad Bank to resolve NPAs effectively there must be adequate guidelines and frameworks from the very beginning, firstly, to determine the value at which assets shall be transferred and secondly, to determine how these NPAs shall be resolved. The major issue ARCs have been facing is to reach an agreement on the value at which banks can sell off the NPAs. Moreover, in the case of ARCs, the RBI launched guidelines on sale of stressed asset by banks in 2016 much after the enactment of SARFAESI Act.

    Banks have been selling NPAs to ARCs either by an auction or bilateral negotiations. However, auction cannot be a suitable way for Bad Banks to acquire NPAs as it will further complex the entire time bound procedure the Bad Bank needs to follow.

    One of the key aspects of having PPP structure is the profit sharing link between the owners of the Bad Bank. Framework may include links of profit sharing between the owners of the Bad Bank so that once the bad asset has been resolved by the Bad Bank the profit will accrue to the owners of Bad Banks i.e. the banks, the original institution itself. If the banks have a profit sharing link then they would not shy away from transferring assets to Bad Bank without any unnecessary delay.

    Timeline: Timeline in which the assets need to be resolved by the Bad Bank is crucial to the entire resolution process and must be strict. Bad Bank should be able to resolve the acquired NPAs within 5 years which can be extended up to 7 years in special circumstances. The extension must not give any leverage otherwise it can start a vicious cycle of bad loans all over again.

    No Barriers to foreign skills and capital: The valuation mismatch between ARCs and bank is because ARCs have been under capitalised due to stringent policies for foreign investors to invest in ARCs which were relaxed only in 2016. This has been the major cause for ARCs limited role in resolving NPAs. The same shall not be done with the Bad Bank, foreign investors must allowed to invest in the Bad Bank from the very beginning so that the Bad Bank does not remain under capitalised.

    Along with the investors, Bad Bank shall also include experts from all around the globe to deal with complex NPAs. Also, in an event when it takes time to resolve NPAs, it’s the experts who can use their expertise to deal with the assets meanwhile a suitable buyer can be found.

    Having a Bad Bank will let the banks continue the lending however, it will bring its own challenges but this seems be to be the best suited time for its incorporation for the recovery of the banking sector. It’s also significant to not completely rely on a successful model of a foreign nation as India will need its Bad Bank to meet its own challenges. Since, the resolution procedure stands suspended in such circumstances banks specially the Public sector banks need to have confidence to keep up the lending. In such circumstances it’s important to segregate distressed assets and let them be realised by the experts.